Is It Time To Buy Convertible Bond CEFs?
Summary Convertible bond CEFs have been hit hard lately, resulting in historically large discounts. Convertible bond CEFs offer enticing income while you wait for the sector to recover. My pick is NCZ, which is currently selling at a large discount and provides a distribution of 12%. In February of this year, I wrote an article advising investors to beware of convertible bond closed end funds (CEFs). At that time, I cautioned that premiums could disappear. As it turned out, my fears was well founded. In July of this year, the premiums morphed into large discounts. After the selloff, I now believe some of these CEFs are selling at bargain levels. Part of my reasoning is based on the currently large negative Z-scores associated with these CEFs. Z-score is a metric popularized by Morningstar and is a measures how far a discount (or premium) is from the mean discount (or premium). The Z-score is computed in terms of standard deviations from the mean so it can be used to rank CEFs. A negative Z-score indicates that the current discount is larger than the average discount over the past year. A Z-score more negative than minus 2 is relatively rare, occurring less than 2.25% of the time. A good source for reviewing Z-scores is the CEFAnalyzer website. Most of the convertible CEFs currently have Z-scores more negative than minus 2. Before jumping into analysis of the risk versus rewards of convertible CEFs, I will recap some of the characteristics of this asset class. A “convertible security” is an investment that can be converted into a company’s common stocks. A company will typically issue a convertible security to lower the cost of raising money. For example, many investors are willing to accept a lower payout because of the conversion feature. The conversion formula is fixed and specifies the conditions that will allow the holder to convert into common stock. Therefore the performance of a convertible is heavily influenced by the price action of the underlying stock. As the stock prices approaches or exceeds the “conversion price” the convertible tends to act more like an equity. If the stock price is far below the conversion price, the convertible acts more like a bond or preferred share. Convertible bond CEFs usually contain a mixture of convertible securities and high yield bonds. The attraction of convertible CEFs is that they offer upside potential with some protection on the downside. Granted that with a portfolio of high yield bonds and convertibles the downside protection is limited. However, over the long run, the fund manager seeks to obtain the “sweet spot” between fixed income and equity that will enable him to outperform his peers. The funds that were analyzed in my previous article are summarized below. AGIC Convertible and Income (NYSE: NCV ). Over the past 5 years, this CEF has sold mostly at a premium, sometimes as high as 14%. It was not until the second half of 2015 that the fund began selling at a discount. The five year average has been a premium of 7.5% and the 1 year average was still a premium of 5.7%. The fund is now selling at a discount of over 10% and has a Z-score of negative 2.55. The portfolio consists of a combination of convertible bonds (58%) and high yield bonds (41%). Less than 10% of the holdings are investment grade. The fund utilizes 33% leverage and has an expense ratio of 1.2%. The distribution is 12.5%, funded by income with no return of capital (NYSE: ROC ). AGIC Convertible and Income II (NYSE: NCZ ). This is a sister fund to NCV and over the past 5 years, the prices of these two funds have been 90% correlated. So if you invest in one of these funds, you gain virtually no diversification from investing in the other. Over the past 5 years, this CEF has sold mostly at a premium, sometimes as high as 17%. It was not until the second half of 2015 that the fund began selling at a discount. The five year average has been a premium of 10.4% and the 1 year average was a premium of 9.4%. The fund currently sells for a discount 9.4% and has a Z-score of negative 2.4. The portfolio consists of a combination of convertible bonds (57%) and high yield bonds (42%). Less than 10% of the holdings are investment grade. The fund utilizes 33% leverage and has an expense ratio of 1.2%. The distribution is 12.4%, funded by income with no ROC. Calamos Convertible and High Yield (NASDAQ: CHY ). Over the past 5 years this CEF has sold for a both a discount and a premium. The premium was as high as 5% in early 2015 but by late 2015 the fund sold at a discount. The 5 year average discount has been 2.9% but over the past year, the fund averaged a slight premium of 0.3%. The current discount is 8.6%. The portfolio consists of a combination of convertible bonds (55%) and high yield bonds (40%). Less than 15% of the holdings are investment grade. The fund utilizes 29% leverage and has an expense ratio of 1.5%. The distribution is 10.6%, funded by income with only a small amount of ROC. The UNII is negative and quite large when compared with the distribution, which may be a concern for maintaining future distributions. Calamos Convertible Opportunities and Income (NASDAQ: CHI ). Over the past 5 years this CEF has sold for a both a discount and a premium, alternating frequently between discount and premium. The premium was as high as 4% in 2011 but by late 2015 the fund sold at a large discount approaching 14%. The 5 year average discount has been less than 1% and over the past year, the fund’s average a discount has been 1.8%. The fund is currently selling at an 11% discount and has a Z-score of negative 2.05. The portfolio consists of a combination of convertible bonds (56%) and high yield bonds (39%). Less than 15% of the holdings are investment grade. The fund utilizes 28% leverage and has an expense ratio of 1.5%. The distribution is 10.9%, funded by income with only a very small amount of ROC. The UNII is negative and quite large when compared with the distribution, which is red flag for future distributions. This is a sister fund to CHY but over the past 5 years these two funds have only been 80% correlated so you receive a small amount diversification if you own both of these CEFs. Advent Claymore Convertible and Income (NYSE: AVK ). Over the past 5 years, this CEF has always sold at a discount. The five year average has been a discount over 8% and the 1 year average is an even higher discount of 10.5%. The current discount is a large 16.8%, which translates into a Z-score negative 2.78. The portfolio consists of a combination of convertible bonds (64%) and high yield bonds (31%). About 10% of the holdings are investment grade. The fund utilizes 37% leverage and has an expense ratio of 2%. The distribution is 8.1%, funded by income with a substantial (40%) ROC component. UNII is negative and large compared with the distribution. Advent Claymore Convertible Securities and Income (NYSE: AGC ). Over the past 5 years, this CEF has usually sold at a discount. The only premium was for a short time in 2010 and was less than a 5% premium. The five year average has been a discount of 8.7% and the 1 year average is an even higher discount of 13.8%. The current discount is over 17%, which translates into a Z-score of negative 1.95. The portfolio consists of a combination of convertible bonds (63%) and high yield bonds (28%). The portfolio also has a small (5%) equity component. About 10% of the holdings are investment grade. The fund utilizes 40% leverage and has an expense ratio of 3.1%. The distribution is 10.1%, funded by income with a substantial (70%) ROC component. UNII is negative and large compared with the distribution. Even though AGC is in the same family as AVK, the prices of these CEFs have been less than 60% correlated over the past 5 years. As a reference, I compared the performance of the convertible CEFs to the following exchange traded fund (ETF). SPDR Barclays Convertible Securities (NYSEARCA: CWB ) . This is the largest and most liquid convertible bond ETF. The fund was launched in 2009 and holds about 100 convertible bonds. ETFs are constructed so that they typically sell very near NAV, so there is no discount or premium. ETF has an expense ratio of 0.4% and yielded 4.5% over the past year. To assess the performance of the selected CEFs, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each of the component funds over the past 5 years (from August, 2010 to August, 2015). The risk free rate was set at 0% so that performance could be easily assessed. This plot is shown in Figure 1. Note that the rate of return is based on price, not Net Asset Value (NAV). (click to enlarge) Figure 1: Reward versus risk over past 5 years The figure indicates that there has been a wide range of returns and volatilities associated with convertibles CEFs. For example, NCV had a high return but also a high volatility. Was the return worth the increased volatility? To answer this question, I calculated the Sharpe Ratio for each fund. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the figure, I also plotted a red line that represents the Sharpe Ratio of NCV. If an asset is above the line, it has a higher Sharpe Ratio than NCV, which means it has a higher risk-adjusted return. Conversely, if an asset is below the line, the reward-to-risk is worse than NCV. Some interesting observations are apparent from the plot. With the exception of AGC, the convertible CEFs had a respectable return over the past 5 years even though they recently sold off. Since CWB did not sell at a premium or a discount, it is not surprising that it had the best risk-adjusted performance over the period of the analysis. Looking at only CEFs, CHY, CHI, and NCV had nearly the same risk-adjusted performance. NCZ was close behind. AGC was the worst performer and only barely stayed in positive territory. The volatility of convertible CEFs ranged from about 15% to 17% (this is similar to the volatility of the S&P 500 over the same period) The 5 year look-back data shows how these funds have performed in the past. However, the real question is how they will perform in the future when the bull market in convertibles returns. Of course, no one knows, but we can obtain some insight by looking at the most recent bull market period from June, 2012 to September, 2014. Figure 2 plots the risk versus reward for the funds over this bull market time frame. As expected, all the funds did well. The performance of the CEFs were tightly bunched but NCZ was the clear leader among the CEFs. Somewhat surprisingly, CWB still turned in the best risk-adjusted performance. However, NCZ had the best return on an absolute basis. (click to enlarge) Figure 2 Risk versus reward over a convertible bull market Bottom Line Convertible bond CEFs have taken it on the chin lately and the discounts have widened to historic proportions. Is it time to buy these CEFs? To my mind, the answer is yes, especially NCZ. NCZ is currently selling at a discount, which is rare. If the discount reverts back to the mean, you will receive a capital gain along with collecting 12% in distributions. Not a bad combination! Of course, the discount could widen and it may time a long time for this CEF to recover, but I am willing to wait. CHY has had exceptional performance in the past and is also selling at steep discounts. This would be another alternative but I am a little worried about the large UNII and ROC. If you are risk adverse, you may want to consider CWB. There is no doubt this is the best in terms of risk-adjusted performance. However, you will not receive any “reversion to the mean” benefits. I normally choose asset with the best risk-adjusted returns but in this case, I am willing to take a slight gamble and go with NCZ. This is a special situation where I think I can capitalize on the selloff in CEFs and hope for that the large discount associated with this CEF will revert back to the mean.